When I posted yesterday’s blog entry, I was only fixated on a simple issue: revaluing a composite for large cash flows from new accounts when using the aggregate method. The GIPS(R) (Global Investment Performance Standards) permit the use of the aggregate method, along with two asset-weighted methods, to derive composite returns. And a recently published Q&A on the GIPS website states that the 1 January 2010 requirement to revalue portfolios for large flows also applies to composites when deriving returns using the aggregate method. And while I didn’t entirely object to this requirement, I do in the case of new accounts being added during the period, as noted in yesterday’s post.

However, I have begun to think about the aggregate method a bit more, as I said I would. I have concluded that there are three issues worth considering:

1. When using the aggregate method, should the firm revalue when a new account is added during the period? I think that I demonstrated that doing so can result in erroneous and/or misleading results.
2. When using the aggregate method, should (as required by the GIPS Q&A) the composite be revalued for large flows (other than for new accounts)? Here, I believe there is evidence to suggest that by revaluing the result will be more accurate, and so I’d say “yes.”
3. Should the aggregate method even be permitted? Or, if permitted, should caution be given in its use? Clearly, this is a much more sweeping question and I have concluded that this method is potentially flawed, both in theory and in reality and should no longer be permitted.

A number of years ago I was doing a talk in Europe on the various attribution linking methods: I presented the Menchero and Cariño models, and then a somewhat naïve approach, which was much more intuitive. Jose Menchero was in attendance and after my talk asked to give him 24 hours to disprove the naïve method. And sure enough, the following day Jose gave me an example which, when using this method, yielded a counter intuitive result. In science, all we need is one example to disprove a theorem.

And we have such a case with the aggregate method:

In this example we have three accounts, each of which experienced a 4.00% return for the period. Halfway through the month, the third account had a 30% cash flow. At mid period, you can see that one account was up 1%, one was down 1%, and the third was even. If we revalue for the flow, the aggregate method yields a return of 4.10%; if we don’t, the result is 4.29 percent. Do either make sense?

The composite return is supposed to reflect an average of actual results: but the actual results were all 4.00%; it appears that our aggregate method generated composite return overstates what actually occurred. Both asset-weighted methods produce correct results. No one is managing the composite, so what does it matter how the composite did?

A colleague, whose opinion I value greatly, offered the following:

I totally agree…it is only logical that the cash flow rule should apply.  But in this case, logic fails.

In our July newsletter I will provide additional examples which call into question the aggregate method’s efficacy as a composite return method.